Cost flows in organization

To compute product costs, management accounting systems should reflect the actual cost flows
in organizations. Manufacturing, retail, and service organizations have very different patterns
of cost flows resulting in different management accounting priorities.

1. Manufacturing organization

Manufacturing costs are usually classified into three groups: direct materials, direct labor, and
manufacturing overhead.

2. Retail Organization

As goods are purchased, their cost is entered into an account that accumulates the cost of
merchandise inventory in the store. Stores incur various overhead costs such as labor,
depreciation on the store, lighting, and heating.

3. Service organization

Unlike retail operations where the major cost item is merchandise, in service organizations the
major cost item is usually employee pay. In such service organizations the focus is on
determining the cost of a project. Since salaries and wages often comprise 80% or more of total
project-related costs.

Some important cost term:

1. Cost object  anything for which a cost is computed
 2. Consumable resources  The defining characteristic of a consumable resource, also
called a flexible resource, is that its cost depends on the amount of resource that is used
3. Capacitiy related resource  The defining characteristic of a capacity-related resource
is that its cost depends on the amount of resource capacity that is acquired and not on
how much of the capacity is used
4. Direct cost  a cost that is uniquely and unequivocally attributable to a single cost
object
5. Indirect cost  Any cost that fails the test of being a direct cost

Handling Indirect Cost In a Manufacturing Environment

The first step in cost assigning is to classify the cost as direct or indirect. If the cost is direct it
is assigned directly to the appropriate cost object. If the cost is indirect, it is assigned to an
indirect cost pool (there can be one or many). An appropriate portion of the indirect cost is then
allocated from the cost pool (or pools) to the cost object (or objects). The simplest structure in
a manufacturing system is to have a single indirect cost pool for the entire manufacturing
operation, which are usually called fixed manufacturing overhead. Some organizations create
another category called variable overhead, which includes costs for such items as machine
electricity usage, minor materials grouped as indirect materials (thread, glue, etc.), and machine
supplies. Because the total indirect costs for the year are not known until after the year end,
when all the costs have been accumulated, organizations allocate indirect costs to production
during the year using a predetermined indirect cost rate. The first step in developing this rate
is to determine the basis, often called the cost driver. Once the cost driver is chosen, cost
analysts divide expected indirect factory costs by the number of cost driver units to compute
what is called the predetermined indirect cost rate. Other common names for this rate include
predetermined overhead rate and cost driver rate.

Job Order and Process System

Job order costing is a system for assign manufacturing cost to an individual product/services
or batches of products/services. Generally, the job order costing system is used only when the
products/services manufactured are sufficiently different from each other. Examples of
situations in which job order costing might be used include a consulting engagement for a
client, building a nuclear reactor for a power utility, providing a meal from a restaurant menu,
or treating a patient in a hospital.
Process costing is an approach to costing that is used when all products are identical. The total
cost of all products is determined by adding up all of the direct and indirect costs used to
produce the products and then dividing by the number of products produced to get a cost per
unit. Examples of products for which process costing is appropriate are soda drinks, breakfast
cereal, plastic water bottles, and routine services such as providing influenza inoculations at a
medical clinic.

Source:

A.A. Atkinson, R.S. Kaplan, E.M. Matsumura, and S.M. Young. 2012. Management Accounting:
Information for Decision-Making and Strategy Execution. Upper Saddle River: Pearson Prentice Hall